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October 09, 2012

Use Stocks, Not Options As a Solution to Dilution

Jill and Carl Hardwork were in the final stages of negotiating the sale of their company. For 10 years they worked tirelessly to build their business from a bright spark in their minds to a successful, profitable company. Being a small fish in a big pond, their success drew notice from the “big boys” and now this deal was about to close. We were introduced to them to talk about how to plan for their tax bills relating to the impending sale.

Carl, the CTO of the company, handled the bulk of the couple’s finances. He outlined the economics of the deal to us, specifically as it related to their personal take. He explained that they were expecting to get about $20 million of cash proceeds. Although that represented a nice chunk of the entire deal, it became immediately clear that the founders’ stock portion of their proceeds would be miniscule.

“Yeah,” Jill, the CEO explained ruefully, “we had to raise so much money over the years that our founders’ shares represent less than 1% of our final take. But the investors were smart; they knew they needed us to stay motivated so most of our equity is nonqualified stock options now. Of course, we are also going to get an equity package as part of our new compensation arrangement with the buyer.”

We were astounded. To get so heavily diluted was one thing—sometimes you need to do that if you are going to make the dream come true—but to end up with stock options as the solution was a real shame. The income tax bite would cut their net cash nearly in half! The new equity they receive as part of their new deal, in reality, should not count. THAT should be their entitlement to the value they create in the future for the work they do after the deal.

Here is how the tax economics work: Selling founder’s stock, after owning it for 10 years, would generate a maximum federal income tax bite of 15% (in 2012). However, cashing out their stock options will cost them about 36.5% in federal taxes. Exercising and selling or simply cashing out these options (they were basically all nonqualified options) generates the same answer for Carl and Jill: a huge incremental tax bill.

This was no surprise to them. As Jill explained, “We looked at other options like stock grants or loans. We were advised they wouldn’t work because our valuation kept increasing. So we were stuck with stock options.”

That advice cost these founders millions of dollars.

Many emerging companies and their founders get seriously diluted through rounds of venture capital financing. They give away stake in the company in order to secure the essential funding they need to make that company successful. Like the entrepreneurs in this example, many do this by granting stock options. What entrepreneurs don’t realize is that with this approach they are setting themselves up for an ugly tax situation down the road. If you are in this kind of situation, there are other options to evaluate before caving in on a really bad tax answer.

In today’s world, the name of the game for key founders, executives, and other talent should be equity compensation in the form of stock. Not options. Stock. This is because stock, after it is owned for a year, can be sold and taxed at the lowest possible tax rates — anywhere from zero to 15% in 2012. Starting in 2013, the range will begin at least at 3.8% and could run as high as 23.8% depending on what games the politicians play. Contrast that with a stock option where an exercise and sale in connection with an exit will be taxed at the highest possible federal tax rate — next year potentially over 40%.

Here are some practical approaches to operating a company when dilution is a fact ...